Interviews

I've been reading research on organizational size and performance as it is pertinent to the book that Huggy Rao and I are writing on scaling-up excellence. In doing so, I also have been following the debate about banks and whether the assertion that both a cause of the meltdown and a risk for future fiascoes is that banks are "too big to fail." Of course, the debate is hard to sift through because there is so much ideology and so many perverse incentives (example: the bigger the bank, the more the CEO, top team, and board will -- in general -- be compensated).

Although bankers have been generally silent on this, some have started speaking-up since former Citigroup CEO Sandy Weil -- the creator of that huge bank (which lives on courtesy of the U.S. taxpayers) -- joined the chorus and argued that big banks ought to be broken-up. Simon Johnson -- an MIT professor -- had an interesting editorial in the New York Times yesterday where he reviews some of the recent arguments by bankers and lobbying groups that very big banks are still a good idea -- and refutes their arguments (and points out that both Democrats and more recently Republicans are starting to challenge the wisdom of mega-banks).

I especially want to focus on the "economies of scale argument," that there are more efficiencies and other advantages enjoyed by larger systems in comparison to smaller ones. This appears to be the crux of an editorial in defense of large banks published in the NYT on August 22nd by former banking executive William B. Harrison Jr. I was struck by one of Johnson's retorts:

As I made clear in a point-by-point rebuttal
of Mr. Harrison’s Op-Ed commentary, his defense of the big banks is not
based on any evidence. He primarily makes assertions about economies of
scale in banking, but no one can find such efficiency enhancements for
banks with more than $100 billion in total assets – and our largest
banks have balance sheets, properly measured, that approach $4 trillion.

Although I am interested in -- and an advocate -- of the power of growing bigger and better organizations at times, doing so is only justifiable in my view if excellence can at least be sustained and preferably enhanced, and the side-effects and risks to do not overwhelm the benefits. Unfortunately, the optimism among the bigger is better crowd often outruns the facts. For starters, I would love to see sound evidence that really really big organizations enjoy economies of scale and other performance advantages -- Wal-Mart might be such a case, they certainly have market power, the ability to bring down prices, and brand recognition -- but I can't find much systematic evidence for economies of scale across really big organizations. If Mr. Harrison is correct, for example, there isn't any evidence of increased efficiencies for banks over 100 billion in assets.

This debate reminds me of some fascinating research on the differences between cities and companies. Luis Bettencourt and Geoffery West of the Santa Fe Institute present fascinating evidence that larger cities are more efficient and effective than smaller ones. As they conclude in this article in Nature:

Three main characteristics vary systematically with population. One, the space required per capita shrinks, thanks to denser settlement and a more intense use of infrastructure. Two, the pace of all socioeconomic activity accelerates, leading to higher productivity. And three, economic and social activities diversify and become more interdependent, resulting in new forms of economic specialization and cultural expression. We have recently shown that these general trends can be expressed as simple mathematical ‘laws’. For example, doubling the population of any city requires only about an 85% increase in infrastructure, whether that be total road surface, length of electrical cables, water pipes or number of petrol stations.

OK, so it seems that economies of scale do exist for at least one kind of social system, cities. Does this provide hope for those bankers? Apparently not. Check out West's Ted Talk on "The Surprising Math Cities and Corporations." He concludes several interesting things about scaling. First, the bigger the biological system, the more efficient it becomes. Second, following the above quote and the logic that follows from organisms, cities become more efficient (and creative and financially successful too) as they become larger. Third, that cities rarely die, but organizations almost always do (he claims always). Fourth, he shows that companies do scale -- in fact he talks about Wal-Mart, shows their economies of scale, and describes his dataset of 23,000 companies. But the twist is that as companies become larger and older they become weighted down with bureaucracy and -- unlike cities -- the resulting internal friction both outweighs the benefits of economies of scale and renders them unable to to pull-off the radical innovations required to stay alive.

This raises the obvious question: Why are corporations so fleeting?
After buying data on more than 23,000 publicly traded companies,
Bettencourt and West discovered that corporate productivity, unlike
urban productivity, was entirely sublinear. As the number of employees
grows, the amount of profit per employee shrinks. West gets giddy when
he shows me the linear regression charts. “Look at this bloody plot,” he
says. “It’s ridiculous how well the points line up.” The graph reflects
the bleak reality of corporate growth, in which efficiencies of scale
are almost always outweighed by the burdens of bureaucracy. “When a
company starts out, it’s all about the new idea,” West says. “And then,
if the company gets lucky, the idea takes off. Everybody is happy and
rich. But then management starts worrying about the bottom line, and so
all these people are hired to keep track of the paper clips. This is the
beginning of the end.”

The danger, West says, is that the inevitable decline in profit per
employee makes large companies increasingly vulnerable to market
volatility. Since the company now has to support an expensive staff —
overhead costs increase with size — even a minor disturbance can lead to
significant losses. As West puts it, “Companies are killed by their
need to keep on getting bigger.”

There are still advantages to size despite these rather discouraging data: market power, legitimacy, the ability to do complex things that require multiple disciplines, and brand recognition come to mind. And there are studies by economists that show economies of scale help under some conditions. Some organizations are also better than others at limiting the burdens of bureaucracy as they grow-- Wal-Mart is one of them.

As a practical matter, when I think of Bettencourt and West's data and combine it with Ben Horowitz's amazing post on scaling, it appears his advice to "give ground grudgingly," to add as little structure and process as you can get away with given your organization's size and complexity, is even more sound than I originally thought.

As with many researchers, West has a healthy ego and states his findings with more certainty than is probably warranted. But these are -- unlike the bankers -- evidence-based statements, and when I combine them with what Huggy and I are learning about how hard scaling is to do well (there are big differences between companies that do it well versus badly), the lack of evidence for economies of scale in really big banks, and a system where the primary defenders of really big banks have strong incentives and weak evidence to support their positions, I am hoping that in a political season where my country seems hopelessly split on so many issues, perhaps this is one where both sides can come together and hold an evidence-based position.

One of our most charming and well-read doctoral students (he is just finishing-up, in fact, I believe he is already a Ph.D), Issac Waisberg, just sent an old quote that is pretty funny. I apologize to my economist friends, but recent global events make this comment seem more true than ever:

"I have been careful not to say that
the pure economist is valueless but, if I may borrow one of his own
conceptions, his marginal utility is low." F. S. Florence, The Economist,
July 25, 1953, 252.

If you check-out the link, you will see Bagehot was the editor of The Economist a long stretch in the 19th century" "For 17 years Bagehot wrote the main article, improved and expanded the
statistical and financial sections, and transformed the journal into one
of the world’s foremost business and political publications. More than
that, he humanized its political approach by emphasising social
problems." It sounds like he was great editor, but I still love the snarky and well-crafted dig.

The debate about the effects of business schools continues over at Harvard Business Review Online. As I've written here, I am largely on to other things. I did learn some interesting lessons along the way, and -- consistent with trying to have strong opinions that are weakly held -- revised my opinions in the face of new arguments. Perhaps my main three conclusions are:

1. Yes, economic assumptions can be dangerous and the worst are sometimes passed along during MBA education. But to simply say that all economists have the same assumptions and they are all evil is too much of an oversimplification. There are many nuances, and many faculty who weave economic assumptions into their teaching and research promote selflessness and cooperation.

2. I do believe that raw individual self-interest and the capitalist way of life are accurate descriptions of how people behave at times and have much practical value. But I don't believe that these are hardwired (following much research)or are the only assumptions that people do or should act on. My view at this point is that applying many economic assumptions is useful, but only in moderate doses and with proper precautions.

3. The question of whether what MBAs learn about economic assumptions or anything else that has any impact at all is important to ask. So many other powerful forces are at work -- self-selection bias, societal norms, business culture, the legal system, and on and on -- that pinning the blame or credit on what MBAs or others who get management education learn or don't learn strikes me as hubris on the part of faculty. In particular, I would argue that the assumptions held and implemented by people who design and run companies matter far more -- if they accept and implement practices that reflect beliefs, for example, that instilling nasty "I win you lose" competition is the path to success (that your co-worker should be your enemy, as one CEO put it) or that people are self-serving with guile (and, perhaps by extension, "it isn't cheating if you don't get caught")-- then the negative effects can be quite large.

Finally, over The Curious Capitalist at Time Online Justin Fox picked out some of the main elements of the debate, quoting Steve Kaplan and me. But I thought this quote from Dev Patnaik was especially thoughtful, as it made me stop and think -- perhaps we need to start teaching people that they don't always have to be so damn sure of themselves. Even if business schools and others that provide management education have no impact at all, he makes a crucial point:

Business schools moved to a model that emphasized quick thinking,
confident elocution and a style of reasoning that looked more like
combat than it did contemplation. Indeed, the entire case study
approach values explicit data (economic or otherwise) at the expense of
intuition, snappy answers at the expense of thoughtful questions, and
competition at the expense of collaboration. Students are rarely
encouraged to confess “I don't know, but wonder if…” They're instead
encouraged to look like they know the answer, whether they know it or
not. We didn't just teach students that economists view people as
self-serving with guile. We taught students that they should be
self-serving with guile if they wanted to do well in our classes. And
we taught them the “soft skills” they needed to get really good at it.